INSIGHT

Are Bonds still relevant – Citi Insight

January 2017

Are bonds still relevant? Investment tips for 2017

Many investors were no doubt surprised to realise that a Trump rather than a Clinton administration will be leading the United States for the next four years. Following the election outcome, there's been invigorated expectations for stronger US economic growth and higher inflation due to Trump's large fiscal expansion plans, which are anticipated to include tax cuts and a sizeable boost to infrastructure spending.

Additionally, the US Federal Reserve increased the Fed Funds Rate in December 2016 for the first time in 12 months, with indications that there may be further rate increases on the cards in to 2017 and beyond.

As a result there has been a regime shift in yields as they leapt from their historically low levels. Considering these recent events, many investors are asking: are bonds still relevant?

"There has been a change in course of investment flows from government bonds to corporate bonds, a pivot towards shorter to medium term duration and a shift from bonds to equities investment," observes Simson Sanaphay, Investment Strategist with Citibank Australia.

Sanaphay however believes bonds remain a central part of any diversified investment portfolio. "Over the past decade, bonds have shown an ability to weather both political and economic volatility."

He points out that US long rates can influence the yield curve of other countries - including Australia. However, he believes bonds remain a central part of any investor's portfolio.

"We think for the Australian investor, the RBA has a high bar for cutting rates further given the potential for negative spill overs from already high levels of Australian household debt and a Federal Government set on achieving a budget surplus in FY21. This challenges the idea of higher local interest rates like what you're currently witnessing in the United States. So Australian investors will remain on the hunt for yield," Sanaphay surmises.

Sanaphay suggests investors seeking a defensive portfolio diversification consider fixed income investments, which may offer recurring income and the potential for higher yields.

Floating Rate Notes (FRNs)

A Floating Rate Note is a bond with a variable coupon, with each periodic payment linked to the prevailing level of an underlying interest rate benchmark - such as the quarterly US LIBOR (London Interbank Offered Rate) for USD denominated FRNs or the quarterly Bank Bill Swap Reference Rate (BBSW) for AUD denominated FRNs.

"Investors may benefit from Floating Rate Notes, especially if they have a view that yields will increase in the future as they benefit from rising coupon payments" he notes. "FRNs offer yield, but at the same time minimise bond price sensitivity to higher rates," explains Sanaphay. "They typically perform well when short-term interest rates are rising."

This is particularly topical to investors who hold USD. Despite the increase in US yields, returns on USD cash haven't been as rewarding. To achieve real rates of return investors should be thinking about taking advantage of FRNs to increase cashflow and adapting to a potentially higher yield environment.

"Citi remains positive on the Investment Grade corporate bond market; however recognise that higher yields pose a risk for bond investors, warranting a more nimble rates exposure when compared to the past few years."

Corporate bonds with a neutral duration timeframe

So far, bond yields have increased in anticipation of a Trump administration's expansionary policy tilt, so another valid question for investors is: how far can yields run?

Sanaphay says. "Well, it's important to be mindful that higher US yields have spillovers that in itself act as stabilisers, higher yields may lead to higher borrowing costs and stronger USD which may in turn dampen US and global economic growth. There are likely to be negative spillovers to emerging markets and a still weak Euro economy will likely see investors in a global capital market step up as buyers of US bonds, limiting the degree of higher yields."

Citi's current preference is to seek investment grade corporate bonds towards neutral (5 to 7 years) duration.

"It's a question of allocating funds to the right class of bonds, and minimising interest rate risk through duration," says Sanaphay. "Long duration government bonds face the most price risk as government bond prices overshot, pricing in Brexit concerns which haven't materialised and ignoring better US data at the time."

When looking for opportunities, specific sectors to watch for include industrials, commodities and financials.

"As reflation and growth are our overall investment themes, US credit with financials should benefit from steeper yields - and US corporates overall should benefit from expansion policy and deregulation. Meanwhile, the credit outlook in the industrial and commodities sectors have also improved."

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A matter of timing

For investors with longer time horizons, such as until the maturity of the bond, the quality of the bond issuer should be a key consideration.

There is a possibility that if yield curves continue to steepen, bond prices will fluctuate accordingly, so bond investors should be comfortable with the underlying bond issuer's credit strength (and future credit outlook) to hold the bond until maturity.

Citi remains positive on the Investment Grade corporate bond market; however recognise that higher yields pose a risk for bond investors, warranting a more nimble rates exposure when compared to the past few years.

"If you appreciate the spectrum and diversity of bond types and durations, bonds will remain a viable and attractive investment option - especially if you're seeking yield and low volatility returns relative to other asset classes," Sanaphay concludes.

Looking for new fixed income opportunities?

Retail investors can access bonds through Citibank via a managed fund, which will invest in bonds on their behalf. Wholesale Investor Clients - who have an accountant's certificate verifying they have an annual income of over $250,000 or net assets in excess of $2.5 million - can invest in Bonds directly through Citibank. Talk to us today about which option may be right for you.

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